Take advantage of the equity in your home to make renovations, invest in property and more.
Whether you’re planning to access your existing equity to finance a renovation, buy property or fund your “bucket list” retirement plans, a home equity line of credit (HELOC) can help you reach your personal and financial goals.
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What is a home equity line of credit?
A home equity line of credit allows you to borrow money using the equity in your property. Your property acts as collateral for the line of credit, which means if you don’t pay back the loan, the lender can repossess or sell your property.
A HELOC is similar to a loan in that the borrower and lender come to an agreement on how much equity can be borrowed and the time period for when the money needs to be paid back. The lender typically sets the initial limit to the credit line using similar criteria to a regular home loan.
Unlike a regular loan, a HELOC is a revolving line of credit that allows the borrower to access funds as they’re needed, and the money doesn’t have to be used all at once. It works a lot like a credit card. You’re given a set amount you can borrow and a draw period, which is the amount of time you have to withdraw money as you need it — usually five to 10 years.
HELOCs generally come with two different types of draw periods:
- Draw period where you can pay on interest and the principal
- Interest-only draw period
Any amount you pay toward the principal then goes back into your credit line, which means you can borrow it again. Being able to pay down both the interest and principal on your HELOC during the draw period will help you pay off your loan faster.
Once your draw period is up, your repayment period begins. This is when you start paying back the entire balance you borrowed, including interest. Most HELOCs come with a repayment period of 10 to 20 years.
How is interest calculated?
HELOCs usually come with variable interest rates that are tied to a benchmark rate, like the Wall Street Journal prime rate, and fluctuate over time. How you decide to withdraw funds determines how much interest you’ll pay — meaning you’ll only accrue interest on the amount of equity you’re actively using.
For instance, if you have a line of credit for $50,000 but you only need $30,000 for a home renovation, you’ll pay interest on the $30,000 and not the remaining $20,000. If you use another $10,000 for vacation, you’d pay interest on the total amount withdrawn — $40,000 — with a $10,000 line of credit left over.
How much does a HELOC cost?
Some lenders charge monthly or annual fees on a home equity line of credit, with the average annual fee no more than $100.
You may also be charged origination, inactivity and closing fees — depending on your lender.
What fees can I expect with a HELOC?
It all depends on the lender you choose to use, however, these are some of the most common fees that are associated with a home equity line of credit.
- Application fee. Some lenders charge an application fee in order to process your application. In cases where an application fee is charged, it’s not uncommon for the lender to refund the fee if you move forward with the HELOC.
- Appraisal fee. Not all HELOCs have an appraisal fee, but those that do normally charge around $300 to cover the cost for an appraiser to calculate the value of your home.
- Closing costs. The average closing cost is about 2% to 5% of the loan amount. This fee is what you pay to have your home equity line of credit set up. It can include the appraisal fee, the application fee or the attorney’s fee. You can ask your lender to waive this fee, or at least negotiate for better terms.
- Cancellation or early termination fee. If you cancel your home equity line of credit shortly after opening it, you could be subject to an early closure fee of around $100 to $500.
- Annual fee. Throughout the duration of a HELOC, you’ll generally be charged an annual fee of anywhere from $50 to $100, though some lenders waive the fee the first year.
- Transaction fee. There may be a fee every time you draw from your home equity line of credit that is added to the overall loan amount.
- Inactivity fee. You may incur some non-usage charges that could cost you around $100 a year if you don’t draw upon your HELOC annually. Be sure to negotiate to have this fee removed if it’s attached to your line of credit, as there are many lenders who won’t charge you an inactivity fee.
- Prepayment fee. You could be charged a fee of up to $500 if you pay off your balance and close your account within three to five years of opening it.
You can use the money in a home equity line of credit for any legitimate purpose — a vacation, to renovate a home or make repairs, to pay bills or to buy a new car.
You don’t need to notify your lender about what the money will be used for — simply withdraw the money from the account.
How to use a HELCO to invest
If your property is worth $400,000 and you’ve taken out a mortgage of $250,000, then you have $150,000 worth of equity. This is a substantial amount of money that can be used to fund the purchase of another property if you’re looking to diversify your portfolio. Since real estate usually appreciates over time, this could lead to a valuable financial return in the long run. You’ll also get a tax break on any interest paid on an investment with a HELOC.
What are the features of a home equity line of credit?
There are many features of a line of credit that make it distinct from other types of financing.
- Structure. This type of loan allows you to use money from a credit limit as needed — similar to how a credit card works. A borrower could be approved for a $100,000 credit limit, but only use $75,000 of it.
- Draw period. Usually five to 10 years, this is the amount of time you have to withdraw money from your line of credit.
- Repayment period. Typically lasting 10 to 20 years, this period begins after the draw period ends. During this time, you have to make repayments on the total amount you borrowed, including interest.
- Interest is only due on withdrawn amounts. Borrowers only have to pay interest on the amount of money that was used, not on the total amount of available credit. This means that you’re not charged interest on unused money. It’s a good incentive for people to avoid withdrawing extra money and only use as much as they need.
- Credit limit. The credit limit of a HELOC is dependent on your property’s value and the percentage of equity that the lender approves you to borrow against, your credit history and your income. The more your property is worth, the higher your credit limit will likely be.
Pros and Cons
- More accessible. A HELOC is generally easier to obtain than other types of loans and credit cards.
- Can be used for almost anything. The line of credit can be used for any legitimate purpose.
- Flexible access to funds. The funds can be easily withdrawn through a check or debit card linked to the HELOC.
- Can make additional repayments. Extra payments can be made during the repayment period, which can help reduce the amount of interest paid over the life of the HELOC.
- Low interest rates. One of the most attractive benefits of HELOCs is that they often have lower interest rates compared to personal loans or credit cards.
- Difficult to manage. With easy access to such a large amount of money, you’ll need to be financially disciplined to manage a HELOC.
- Risk losing your property. If your line of credit isn’t repaid according to the terms of your contract, the lender can take your property as payment.
How can I protect my home?
From a lender’s point of view, they have the security of using your home as collateral in case you default on the loan. To avoid the lender taking possession of your home if you’re unable to make repayments, don’t borrow against equity that’s been calculated on an inflated price of your home’s value.
That’s because if your home depreciates in value, you’ll end up with less equity. When house values drop, you could end up owing more on the loan than what your home is actually worth.
This is why it’s a good idea not to borrow or use the full amount of equity that’s available — always leave a cushion of funds in case home prices fall. Many lenders require you to keep at least 20% equity in your home for this very reason.
Tips for managing a HELOC
There’s a lot to think about when considering a home loan, no matter what type you’d like to get and what you intend to use the funds for.
Here are some tips to keep in mind:
- Minimize the amount of interest payable on your HELOC by making payments on the principal during the draw period.
- Don’t withdraw more funds than you need.
- Compare a range of HELOCs to ensure you’re getting a competitive deal.
- Keep at least 20% equity in your home in case house prices fall.
How can I apply for a line of credit home loan?
If you’re applying for a line of credit, you’ll likely need to be at least 18 years old and provide the following information:
- Name and address for each borrower.
- Purchase date and price of the home.
- Employment income.
- Income from any other sources.
- Estimated market value of the home.
- Outstanding balance on the current mortgage.
- The monthly payment on the current mortgage.
- Requested loan amount.
- Photo ID for all borrowers.
- Previous address, if at current address less than two years.
- Previous employer, if with current employer less than two years.
How do I compare HELOCs?
The best way to compare HELOCs is to analyze the interest rates and fees.
Lines of credit typically come with lower interest rates than home equity loans, but the rates are normally variable. This means they’ll fluctuate based on movements in a benchmark rate, like the Wall Street Journal prime rate. Some lenders may allow you to convert your loan balance to a fixed rate, however, during the draw period.
Most lines of credit also carry fees to cover the administrative cost of setting up and managing the loan account.
Should I take out a HELOC?
If you’re thinking of taking out a HELOC, you should consider whether:
- You have the discipline to stick to a budget.
- You have not borrowed against equity that has been calculated on an inflated price.
- You have the restraint to not use all the funds at once.
- You have a cash buffer to protect yourself from rising interest rates.
Case study: Leah’s experience
When we decided to finish our basement, we knew we needed to pay for it by taking advantage of the equity we’d built in our home after paying down our mortgage for five years.
We took out a HELOC we could use for anything with a higher credit line than we needed to make the renovations. Since we were stuck with a high APR on some credit card debt, we decided to roll this into our low-rate HELOC as well.
As we started our renovations, we wrote checks from our HELOC account to pay the contractors. We learned quickly that paying the minimum balance only covered the interest, so we made sure to increase our payments when we could.
Our HELOC came with a fixed 2.99% APR for the first year, and then jumped to a variable rate thereafter. We planned to pay off as much as we could that first year to cut the balance in half by the second year. And our loan officer offered to refinance the loan to a fixed rate after the first year, too — as long as we had enough equity in our home.
Overall, we found that a HELOC was an easy and affordable way to get money for our growing family home.
A home equity line of credit can give you a financial cushion. But before you apply, make sure you understand the consequences of what could happen if you fail to pay it back.
Like any line of credit, you should have a firm blueprint of what you can budget toward repayments and a plan of attack for paying back what you owe. If you’ve nailed down both of these factors, then you might want to consider using a HELOC to invest in real estate, start a business, renovate your home or even go on your dream vacation.
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